Forex Fundamental analysis is the method of ascertaining the intrinsic value of a currency pair based on economic events like interest rate, gross domestic product(GDP), consumer price index (CPI), producer price index(PPI), nonfarm payroll number(NFP, for the US) and political events.
Interest rates in Forex
Once you start to learn and trade using Fundamental analysis in forex, you may start wondering which news releases you need to focus on. There are lots of economic news releases happening all over the world. How would you know which news releases play an important role in making a trading decision? A simple rule would be to watch out for the news releases which potentially affect the currency’s interest rate. Let us see why interest rates are important to the value of a currency.
Before we proceed, let us remember a fact: A currency’s economic strength depends on the interest rate. The interest rate is a simple measurement tool to measure the strength of the currency.
Let us see what happens when a country’s economic strength increases. When people can spend more of their income, they will purchase more services and products. This results in an increase in the price of those services and goods. This price increase is called as inflation.
If inflation continues to flourish with absolutely no control, much of the buying power of our money will get reduced. Because of the high price increase, something that costs just a little amount of money today will cost an arm and a leg in the near future. This is actually happening in many countries with high inflation rates. In order to avoid such a hazard before it appears, central bank steps in and increases the interest rates of the currency.
Effect of Interest Rate
If the interest rates are higher, borrowing money or getting loans becomes more expensive. With high-interest rates, you will have to pay a huge amount of interest for personal loans, vehicle loans, and home loans. Many businesses and organizations rely on such loans to grow. Therefore, they will also have to pay a lot of interest on the borrowed money. As the economies slow down, higher rates will start to cause damage. This will continue until a point where the central bank decides to lower the interest rates. This reduction in interest rates will help the economies to grow.
When interest rates become higher, naturally the companies from the foreign countries will be interested to invest in this country. Due to high interest rates, they will get higher returns on their investment. This also increases the demand for this country’s currency. Because of this, countries with higher interest rates, growth in domestic financial markets and the overall economic growth are likely to attract more foreign capital. When the demand for a country’s currency increases, the value of the currency also increases.
This means that the direction of the interest rate represents the demand for a currency. So, for any fundamental analysis, an important thing to check is a currency’s interest rate. Now you may be wondering how we can find out the direction of the interest rate. Fundamental analysts are analyzing central bank statements and look for any signs of what the central bank may do at the next meeting. We need to remember that the expectations for the future interest rate moves are more important than the interest rate decision itself.
Interest rate expectations
So far we have learned that higher interest rates may cause the value of the currency to increase and lower interest rates may decrease the value of a currency. But the current interest rate is not the only criteria that determine whether the value of a currency is going to fall or rise. It also greatly depends on the future interest rate expectations.
In other words, even though a currency’s interest rate is high, if there is no probability of that interest rate to increase in the future, the value of the currency may fall. Similarly, even if the currency has a low-interest rate at present, the value of the currency may rise if the interest rate is expected to rise in the future. So the bottom line is, both the current interest rate and the future interest rate expectations play a major role in determining the market movement. But the latter is more important and that is what most of the Forex traders focus on.
Interest rates have a tendency to shift in line with monetary policy. To be more specific, they shift with the end of monetary cycles. When the rates are going lower and lower, there is a greater chance for the rates to go higher again. Because at some point, the rates will have to increase.
How a currency can affect the world
Any price quote that you see in the currency charts can impact the market and bring huge repercussions to the economy. Even if you don’t see your country’s currency in a quote, it may still have the ability to affect the economy of your country.
Let us take Japanese Yen as an example to understand this. Japan is one of the major exporters in the world. Many countries purchase Japanese goods and it makes Japan’s economy stronger. So, if the Japanese Yen becomes expensive, foreign consumers will find it difficult to buy Japanese goods. This can actually bring down the economy of the country. Because the consumers may choose to purchase the goods from a different country instead of Japan.
Let us say that there is a company in the United States which has been buying goods from Japan. At some point, the company realizes that it can’t afford the prices due to a heavy increase in the value of the Japanese Yen. So, it may decide to buy the same goods from another country. This gives a business opportunity to a manufacturer in a different country.
So it is important to understand that the prices we see in any currency chart have the power to influence the world economy.
Gross Domestic Product (GDP)
Gross Domestic Product (GDP) is a monetary measure of the production and outcome of goods and services of a particular country. Simon Kuznets developed it in the year 1934. A country releases GDP usually for monthly, quarterly and yearly periods. Various countries use various approaches to calculate the GDP. One of them is the Expenditure Approach. The U.S. Bureau of Economic Analysis uses this to calculate GDP.
Here is the formula they use to calculate GDP using the Expenditure Approach:
In the United States, the products and services that they measure using GDP fall into the following categories:
Personal consumption: Food, rent, fuel etc.
Investment: Businesses spending on new equipment, plants etc.
Government spending and investment: Everything spent or invested by the government
Net Exports: Total final exports, minus total imports
Four weeks after the end of the quarter, there is an advance release of GDP. Then three months after the end of the quarter, a final release of GDP. The Bureau of Economic Analysis (BEA) releases both advance and final releases by at 8:30 AM ET. If GDP is too high it can lead to inflation. If it is too low, it can lead to a recession.
Forex traders show interest in GDP because it completely reflects the health of a country’s economy. Traders usually seek higher rates of GDP or growth because usually, the interest rates follow the same direction.
The Consumer Price Index (CPI)
Every month, major economies of the world release a report called ‘Consumer Price Index’. This monthly report gives an overview of the current economic growth and inflation levels of the country.
Consumer Price Index report primarily measures two things: Headline inflation and core inflation. Headline inflation reading tracks the overall changes, including the energy prices which are volatile. Core inflation reading strips out the volatile energy prices and food. It gives a clearer picture of the price changes in the basket of goods.
Headline inflation usually has more volatility. In fact, traders can use headline inflation to predict the core inflation. Central Bankers target this report because of the importance of headline inflation.
Traders consider CPI as one of the most important economic reports because of its ability to show how quickly prices are rising or falling. The rise of the consumer price indicates inflation, whereas the decline in consumer price indicates a period of deflation.Central banks keep a close eye on CPI.They act on the monetary policy if there is a strong or prolonged increase or decline in inflation.
Once a country releases CPI, traders usually check if there is a price breakout or a bounce back below the resistance level. If an earlier uptrend continues by breaking the resistance line, that signals the traders that the uptrend will likely continue.
Producer Price Index (PPI)
Producer Price Index (PPI) measures the average change in the selling prices of raw, semi-finished or finished goods and services. A country’s government releases PPI during the second week of each month. While indexes like CPI measure the change in the price from the perspective of the consumer, PPI measures those changes from the perspective of the sellers. Forex traders pay attention to CPI because it indicates the rise and fall of inflation, which in turn could cause a rise or fall in the currency rates.
PPI focuses on three production areas: commodity based, industry-based, and stage-of-processing-based companies. PPI is a survey that they randomly do on chosen retailers. Bureau of Labor Statistics, the principal fact-finding agency in labor economics and statistics, releases PPI. It covers major industries like agriculture, manufacturing, mining, natural gas, construction and more.
PPI helps Forex traders to find the measurement of inflation and the direction of prices. When PPI is rising, it signals that you can expect an increase in the interest rate. When the interest rate increases in a country, it also increases the demand for that country’s currency. Similarly, if PPI is falling, it could indicate that you can expect a lower interest rate. Since interest rates play a major role in the currency market, Forex traders check the PPI and make their trading decisions by analyzing it.
ISM(Institute for Supply Management) numbers
Institute for Supply Management is the first and the largest non-profit supply management institute in the world. This institute started in 1915 and its services 40,000 business professionals in more than 90 countries. On the first business day of each month, they release Purchasing Managers Index (PMI), to measure the economic growth.
The ISM surveys its large membership of purchasing managers to get information about the supply chain. It uses this information to measure the economic activity from both the manufacturing side and the service side. ISM publishes three types of surveys: manufacturing, construction, and services. Purchasing Managers Index (PMI) is a compilation of surveys collected from over 400 manufacturing purchasing managers. Also, ISM releases construction PMI on the second business day of the month and they release the services on the third business day.
The release of the PMI causes a huge market movement and increase the volatility in the Forex market. They release it at 10:30 ET in the morning. Forex traders focus on the PMI release to make predictions about the US economy and make trading decisions accordingly.
PMI releases have their basis on the previous month historical data which ISM had directly collected from the industry professionals. Traders compare this previous month’s number with the forecasted numbers that the economists publish. If the released PMI number is better than the previous number and higher than the forecasted number, then the price of the US dollar may go up.
US Bureau of Labor Statistics releases Non-Farm Payrolls (NFP) on the first day of every month at 8:30 a.m. EST. It is a report which shows the employment changes in the United States. NFP helps traders to understand whether US economy is expanding or contracting.
NFP calculates the net changes in the employment as jobs are created or subtracted in an economy in any given month. It is called as non-farm because the report doesn’t include farm or agricultural workers. It also excludes certain government employees, private household employees, and nonprofit organizations.
Usually, NFP increases the volatility in the market and creates a lot of trading opportunities on the day when it is released.But it is best to avoid trading NFP if you are not sure what you are doing. Because, the trend can easily go against your expectations. This can cause a large amount of loss if things go wrong. You may need to wait for the wild rate swings to subside and then capitalize on the real market move… While NFP certainly guarantees good trading opportunities, it doesn’t assure profit or loss. So, trading NFP can be risky and dangerous as well.
Using Economic Calendar
Now you know all these different types of important news releases. But how do you actually know at what time different economies of the world release them and keep track of those news releases? You have to use an economic calendar for that.
An economic calendar shows you all the details about the upcoming news releases from the major economies. Economic calendar shows a clear schedule of all the important events and it is available for free on many websites.
It gives you the following information
The time of the news release
The currency that it affects.
The importance of the news release
Prediction about the movement of the currency
The history of economic releases
Economic calendars allow you to filter the information according to what you want to check. They also offer you a way to check the market conditions during a period of time in the past. This helps to know more about the past history and previous trends. Traders can choose to analyze the market based on the importance of the news releases. Because, you will know what news releases are likely to cause a big impact in the market by just seeing which ones are marked with ‘High’ importance.
It is important for the traders to check the economic calendar every morning and note down the times of the major news releases of the day. You need to proceed with caution when you are placing a new trade just before, during or just after an important news release. If you are not sure what you are doing, it is better to not to place an order during the news release. Also, since anything can happen during the news release, professional traders usually close their positions 5-10 minutes before the news release. They also wait for a long time after the news release.
Central Banks Policy and Effect
Central Banks are institutions that nations use to manage their currency, money supply, and interest rates. A Central bank usually has a monopoly on increasing the monetary base in the country. It usually prints the nation’s currency too. Human beings used a central banking authority for the first time as early as about thousand years ago. It happened in China where they issued paper money for the first time.
Federal Reserve of the United States, European Central Bank (ECB), Bank of England (BOE), Bank of Canada, and the Reserve Bank of Australia are some examples of the central banks around the world. A Central bank may influence a single country or a group of countries. For example, European Central Bank administers a monetary policy of the eurozone, which consists of 19 EU member states.
About Federal Reserve of the United States
The Federal Reserve (or just “Fed” in the short form) is the Central Banking system of the United States . Congress created it on December 23, 1913, to ensure a safer and consistently stable monetary system in the United States. After a series of financial panics that happened during the 1990s in the United States, they created FED to have a central control of the monetary system.
The series of financial panics continued until 1907 when the 1907 Bankers’ Panic or Knickerbocker Crisis occurred. This happened over a three-week period starting in mid-October when the New York Stock Exchange fell almost 50% from its peak the previous year. Because of this crisis, many banks and businesses had to close or declare bankruptcy.
United States established FED to avoid such crisis in the future. Here is an example of how the system works. If a ‘run’ on deposit occurs in a local bank because of unexpected withdrawals or regional emergencies, Fed can loan some money to the local bank at a nominal charge known as the discount rate. Once they meet the run, the local bank will return the money to Fed. Fed uses many such policies to administer a monetary policy of the United States.
How Monetary Policy Works
Monetary policy is used to control the supply of money, often targeting an inflation rate or interest rate to ensure price stability and general trust in the currency. Fed uses monetary policy as a tool to achieve its goals. Based on the country’s economy, Fed chooses to either take an expansionary or contractionary policy.
Fed chooses to take the Expansionary policy to expand the monetary base and the decrease interest rates. It selects this policy when there is an economic slowdown. When this policy is acting on, more money becomes available to businesses and banks, which directly increases the growth and development. Because of an expansionary policy, GDP may grow and unemployment may decline.
Fed selects the contractionary policy when the economy is stable and heated up. This policy causes the interest rate to increase and the monetary base to become restricted. The circulation of the total capital becomes less, causing the economy to contract and slow down. When this happens, you can expect a decline in GDP and an increase in unemployment.
Effects on currency rates
Since FED manages the currency, money supply and interest rates of the United States, it has a direct influence on the strength and weakness of the US dollar. When an expansionary policy is active, it increases the monetary base and decreases the interest rates. There is an oversupply of funds which results in a decrease in the value of the US dollar. Also, because of the decline in interest rates, businesses borrow funds more easily. This also results in the decline of the USD.
When the contractionary monetary policy is active, the exact opposite happens. Since the monetary base becomes less, there is a scarcity of the capital. Because of the scarcity, the value of the remaining funds goes up resulting in an increase in the value of a currency. Since interest rate also increases, it becomes more expensive for businesses to borrow money. This also causes the value of the currency to go up.
Forex traders should be aware of the monetary policy that the central bank is taking. Depending on whether the central bank is taking expansionary or contractionary measure, there will be a direct influence on the currency rates.
Federal Open Market Committee (FOMC)
Fed has been working to promote maximum employment, stable price and moderate long-term interest rate in the United States. Federal Open Market Committee (FOMC) meets eight times each year to discuss goals and achievements. They hold these meetings to set the future course of overnight interest rate.
The important attendees of FOMC include the board of governors (7 members appointed by the President and approved by the Senate), the president of the Federal Reserve Bank of New York and 4 of the other 11 Federal reserve bank presidents. The time for the release of data differs. But the usual time is 07:15 GMT i.e. 02:15 EST. Dates and time of the FOMC meeting statement are available on the Federal Reserve website.
Here are the two possible outcomes of FED’S decisions on interest rates:
If the FED increases the interest rate, it would decrease the supply of the US Dollar in the banking system and hence appreciate the value of the USD
If the FED decreases the interest rate, it would increase the supply of the US dollar in the banking system and hence depreciate the value of the USD.
The Fed’s Board of Governors is responsible for setting the discount rate and reserve requirements. FOMC is specifically responsible for open market operations, which involves the buying and selling of government securities.
As a trader, you can be pretty sure that the volatility in the market is going to be pretty high after the release of the FOMC. The trading plan from an FOMC statement gets more clarified in the upcoming the weeks of the release and therefore, is more appropriate for trend traders. Trading exactly before, during or after the event can be very risky. But always watch out for new trends that develop a week or two after the FOMC release.
European Central Bank (ECB)
The ECB is in charge of administering the monetary policy which supports the economic needs of 19 different member states. But remember that not all countries which are in the Eurozone use the Euro currency. The central banks of all 28 EU member states own the capital stock of the bank. The bank came into function in 1998 by the Treaty of Amsterdam. The bank has its headquarters in Frankfurt, Germany.
The ECB has a single legal binding mandated that commits it to maintain price stability above everything. ECB’s single mandate controls the inflation rather than managing the exchange rate. ECB’S main focus is on the inflation. So, when a poor Consumer Price Index (CPI) value comes out, the ECB will usually take action. As a result, the market may start to sell Euros.
Whenever ECB increases, decreases or maintains interest rate, the decision always has a direct effect on the Euro. When interest rate increases, the ECB literally sells Euro government securities to major financial dealers who in turn would pay by transferring money to the ECB account. This will decrease the supply of the Euro in the banking system and therefore appreciate its value. By reducing the interest rate, the ECB literally buys Euro government securities from major financial dealers who in turn would get paid by transferring money into their accounts from the ECB. This would increase the supply of the Euro in the banking system and therefore depreciate its value.